Many investors add an investment in real estate to their portfolio and there are a number of ways to do this depending on how much time and money you are willing to put in.
Many investors add an investment in real estate to their portfolio. Real estate can provide both strong returns and significant diversification benefits due to low correlation with more traditional stocks and bonds. There are a number of ways to add real estate to your portfolio and each comes with its own pluses and minuses.
The least expensive way (in both time and money) to add real estate to your portfolio is simply to purchase publicly-traded Real Estate Investment Trusts (REITS). REITs are leveraged companies that invest only in real estate, and are required to pay out 90% of their earnings to the investors each year as dividends, which is a significant difference from more traditional stocks. Due to these characteristics, many financial experts consider REITs to be an asset class separate from stocks and bonds.
Publicly-traded REITs are bought and sold conveniently and inexpensively any day the stock market is open and can be purchased individually, inside an actively managed mutual fund or inside a passively managed mutual fund or ETF. Passively managed REIT funds through companies such as Vanguard or DFA have expense ratios as low as 0.10% per year.
Critics of REITs label them as “real-estate flavored stock” because they can be even more volatile than the stock market. In the 2008 bear market, the Vanguard REIT Index fund lost 78% of its value at one point. Correlations with the overall stock market have also been rising in recent years.
Correlations are measured using the statistical term R2. Two investments that always act the same way have an R2 of 1. Two investments that are completely uncorrelated have an R2 of 0. Uncorrelated investments provide a great deal of diversification to a portfolio. Even more diversification is provided when the investment has a negative R2.
The R2 between the Vanguard Total Stock Market Fund and the Vanguard REIT Index Fund is 0.85. By way of comparison, the R2 between the Vanguard Total Stock Market Fund and the Vanguard Total Bond Market Fund is -0.50 and the R2 between the U.S. stock market and the non-U.S. stock market is 0.91.
So REITs do provide some diversification, but not that much. REITS are also highly tax-inefficient and, generally, should be held only within a tax-protected account such as a 401(k) or Roth IRA.
There are also privately-traded REITs sold by commissioned salesmen. However, these tend to be products with high commissions, high fees, low transparency and low liquidity and should generally be avoided.
Business-related real estate
Many physicians find the easiest way to invest in real estate is through their practice. Just like the decision to rent or own a home, you can also rent or own the space in which you practice.
Even hospital-based physicians may be able to purchase business-related real estate such as the group’s office space. This asset should generally be placed into a separate business such as a Limited Liability Company to provide liability protection.
The main benefit of owning real estate related to your business is that it provides synergy to your main job. Not only do you get the benefits of owning real estate, but you may reduce your business overhead. You also get to avoid tenant-related issues, since you are the tenant. If your building has room for other businesses, you may be able to acquire tenants that work synergistically with your practice, such as lab, X-ray, pharmacy, physical therapy or other specialists.
Critics of owning the land and building your practice is in point out that it may not be a good idea to tie your investments too tightly to your main income — if the value of one goes down the value of the other almost surely will as well. It can also serve as golden handcuffs, limiting your employment flexibility.
Individually owned property
Many physicians invest directly in rental real estate, whether residential or commercial. This can provide a great return thanks to appreciation of the property, tax benefits such as depreciation, amortization of the loan, and cash flow after all expenses are paid. Individual properties provide very low correlation with the rest of your portfolio and may provide quite stable value and cash flow. The real estate market is also much less efficient than the stock market, making it much easier to find deals that boost your returns.
There are five main issues with owning real estate directly.
1. It is difficult to diversify.
Even on a physician’s income, most investors can only purchase a few properties in their entire career. A REIT owns hundreds of properties all over the country, and a REIT mutual fund may hold dozens of REITs.
2. Property management can be a major hassle.
Real estate author John T. Reed points out that it is very difficult to hire a good property manager due to the nature of the property management business. Since they only make a few dollars a month from each property they manage, there is little incentive to manage a property well, but a great deal of incentive to spread themselves thin by managing as many properties as possible and accept kick-backs from contractors. He recommends that a real estate investor manage his own properties or, if he has enough properties, hire his own employee as the manager.
Physicians tend to be busy and neither interested nor adept at property management. They also have a job where they can trade their time for money at a very high rate, far higher than they could do managing properties. It’s bad enough to get a call at 3 a.m. to take care of someone who needs your help to save their life. It’s far worse to get a call at 3 a.m. about a leaky roof or a clogged toilet.
Owning only one, or a few properties, also doesn’t provide much economy of scale for management, maintenance, and other necessary chores.
3. It is difficult to be a long distance landlord.
This causes most investors in individually owned properties to invest primarily in their home town. It is unlikely that your town is among the best in the country for real estate investing at any given time. The desire to keep your investment close enough to check on may keep you from getting the best purchase price or the best rate of appreciation.
4. Financing for individually owned investment can be problematic.
Ideally, an investment is financed with a non-recourse loan — meaning if it does poorly and is foreclosed on the lender cannot come after you for the difference. However, it is very unusual for an individual property owner to be able to acquire non-recourse financing.
5. Transaction costs for real estate tend to be very high.
Five percent of the value at the time of purchase and 10% at the time of sale are not unusual, necessitating a long holding period to spread these costs out over many years. Since it can take months to sell a property, liquidity is also a serious issue.
Fractional ownership of commercial real estate
Some physicians advocate using a private syndicator to buy a fraction of a larger property rather than individual properties. Instead of buying a $250,000 house with $50,000 down, you could get together with 20 other investors and buy a $5 million property with $1 million down. There are a number of advantages to doing this.
First, you get a professional team doing the acquiring, managing, and liquidating of the property, allowing you to focus on your practice, your family and your hobbies. Second, you are no longer limited to investing in your home town. Third, non-recourse financing is generally available. Last, since you now own perhaps 100 apartments instead of just one house, there are management and maintenance economies of scale available and a vacancy has much less effect.
There are also downsides to investing in real estate this way. First, the minimums can often be quite high: $50,00 to $100,000 is typical. Second, fees can be quite high, with an acquisition fee as high as 5% of the value of the property and ongoing fees as high as 1% of the value of your property. The private syndicator may also take 20% to 33% of the appreciation of the property and amortization of the loan, depending on how the deal is structured. Third, it will cost you time and money if you actually want to go out and inspect the property, since it is unlikely to be in your home town. Fourth, just as with owning properties individually, liquidity may be difficult and you may have to wait months or even years to get your principle back. Last, since these tend to be small, private companies, there is risk that you’ll end up investing with incompetent, or even unscrupulous, folks. Doing appropriate due diligence and perhaps even background checks on the principals can be time consuming and expensive.
Pros and cons
Real estate can provide high returns and wonderful diversification to your portfolio. There are many ways to invest in real estate, but each method comes with its own downsides. Carefully weigh the pluses and minuses prior to adding this asset class to your portfolio.
James M. Dahle MD, FACEP, blogs at The White Coat Investor, where he tries to give those who wear the white coat a “fair shake” on Wall Street. He is not a licensed attorney, accountant or financial advisor and you should consult with your advisors prior to acting on any information you read here.